The theories surrounding monetary policy have been radically transformed in recent decades, ultimately shaping the institutional structure and policies of central banks. The focus until recently was upon \u2018a mandate, independence and accountability\u2019 (Svensson, 2009) which closely reflected theoretical models, however the shifting nature of the economy with the current financial crisis has meant a greater disconnect between theory and practice.<\/p>\n
The Barro-Gordon model depicted the choices policy makers face when creating monetary policy.<\/p>\n
This temptation of a temporary rise in employment is correlated with the pressure on governments to achieve high results before elections. The problem becomes time-inconsistent with rational expectations and a multi-period model. The optimal policy for government is positive inflation, which agents know and thus set expectations equal to. This demonstrates the optimal result of a binding rule.<\/p>\n
The rule vs. discretion debate highlighted the need to constrain government interference, resulting in increasing central bank independence and a focus upon long term horizons. However, rules cannot accommodate all possible events, and have created problems evident in the Thatcher government. The US policy between 1950-66, and 1985-2000 provides evidence that discretionary policy can produce good results. The assumptions of the distinction between only two types of central bankers and perfect control over the price level are deemed unrealistic.<\/p>\n
The granting of Central Bank independence within the UK in 1997 could be seen as a response to the impetus within theoretical literature such as Barro-Gordon to do so. Following this, the MPC was said to gain instant credibility with long-tern inflation expectations falling sharply. Empirical findings below support independent central banks\u2019 ability to sustain lower inflation with no output cost. Central banks tend to follow Fischer\u2019s theory of instrument independence and goal dependence. The idea of \u201cconstrained discretion\u201d is seen in the UK with the Chancellor\u2019s requirement of a remit letter if inflation strays by 1pp from target. The independence of the UK\u2019s Quantitative easing policy is seen by its status of \u201cthe business of the bank\u201d (Mervyn King). However the democratic need for accountability is seen in the UK\u2019s allowance of a member of the treasury to sit in on meetings.<\/p>\n
Reputation and delegation are two theoretical commitment solutions to the dynamic-inconsistency problem. (Romer, 2001). Reputation plays a role in monetary policy, in a state of uncertainty such as the UK, where the image of central bankers of inflation fighting is important to establish credibility thus incentivising them to achieve targets. This issue is seen as being \u201cnear..to the hearts of real central bankers\u201d (Blinder) and is achieved by processes such as publishing votes.<\/p>\n
Commitment solutions rely on the importance of expectations and are prominent in theory and practice of real world policy. This is reflected in the prominent role of the Bank of England\u2019s inflation and output forecasts. However the New Keynesian Phillips Curve assumption that a rise in inflation expectations would give rise to inflation did not hold in recent times, as shown below.<\/p>\n
Rogoffs\u2019 proposal of delegating monetary policy to \u2018Conservative central bankers\u2019 that are more inflation-averse than the general public provided the \u201cintellectual framework for the redesign of the central banks\u201d (Clement, 2008). It has been influential in the Bank of England\u2019s appointment choices with the Conservative views of insiders dominating monetary policy (Spencer, 2009). The need for the \u2018optimal level of conservatism\u2019 explains \u2018flexible inflation targets\u2019 in many central banks, and the inclusion of \u2018outsiders\u2019 within the MPC. The use of a one-shot game and its exclusion of a disinflation possibility (Hallett, Libich & Stehlik) disconnects it from reality.<\/p>\n
Although there is no such inclusion of a \u2018performance contract\u2019 (Walsh, 1995) within monetary policy, the theory drew attention to optimal incentive structures for central banks, which is a current focus in the financial crisis literature. The use of an inflation target which allows for output stabilisation, seen in the Svensson model (1997), is correlates with this theory and is evident in most central banks. Svensson proposes an optimal reaction function similar to the Taylor Rule, which the UK\u2019s MPC is said to follow (Spencer 2009). However due its \u2018individualistic\u2019 (Blinder) nature consolidated in the \u2018one member one vote\u2019 system, one rule could never account for the heterogeneous views within the MPC.<\/p>\n
However Harris & Spencer model (2009) state that \u201cthe institutional status of Bank of England MPC members\u201d holds more importance than differing reaction functions, The MPC contains five insiders appointed from within the bank, and four outsiders, appointed from other professions and academia. Theory correlates with practice, with insiders more likely to hold conservative views and vote as a block, when compared to outsiders.<\/p>\n
The rapid change of the economy in the recent financial crisis has led to a disconnection between theory and practice. The \u2018one tool, one target\u2019 approach has proved inadequate in dealing with the financial crisis. Blanchflower (2009) stipulated the exclusion of the financial sector as the reason the Central Bank was slow to realise the severity of the crisis. The effect of the financial crisis confirms the view that theory arises from events, and their unpredictability means models will always contain shortfalls. Shortfalls are also evident in healthy economies. The complete markets assumption seen in such influential models like the DSGE and the ones discussed above does not hold in a world \u201ccharacterised by herding behaviour & speculative bubbles\u201d (Blanchflower, 2009). Critics cite the inclusion of fiscal policy within models as likely to alter results.<\/p>\n
In conclusion, the models I have discussed have been influential in determining the institutional structure of the bank, the type of central banker appointed and how they are done so. They have signified the importance of the role of bank incentives and expectations in forming policy. However as the recent financial crisis has shown, in such a dynamic complicated world littered with uncertainties, generalised models can never satisfy all the demands of practical monetary policy.<\/p>\n
Bibliography<\/strong><\/p>\n Books<\/strong><\/p>\n Blinder (1999), \u201cCentral Banking in Theory & Practice\u201d<\/p>\n Romer (2001), \u201cAdvanced Macroeconomics\u201d<\/p>\n Articles<\/strong><\/p>\n Barro, (1977), \u201cUnanticipated Money Growth and Unemployment in the United States\u201d, The American Economic Review<\/p>\n Barro, (1978), \u201cUnanticipated Money, Output, and the Price Level in the United States\u201d, The Journal of Political Economy<\/p>\n Fischer (1994), \u201cHow independent should a central bank be?\u201d Working Papers in Applied Economic Theory<\/p>\n Hallett, Libich & Stehlik (2007), \u201cRogoff Revisited: The Conservative Central Banker Proposition Under Active Fiscal Policies\u201d, CAMA Working Papers<\/p>\n Herrendorf, Berthold and Lockwood (1997), \u201cRogoff\u00b4s \u201cconservative\u201d central banker restored\u201d, Journal of Money, Credit, and Banking<\/p>\n Spencer & Harris (2009), \u201cThe Policy Choices and Reaction Functions of Bank of England MPC Members\u201d, Southern Economic Journal<\/p>\n Spencer (2009), Lectures Notes for Loughborough University<\/p>\n Svensson (2009), \u201cOptimal Inflation Targets, \u2018Conservative Central Banks\u2019 and Linear Inflation Contracts\u201d, American Economic Review<\/p>\n Walsh (1995), \u201cOptimal Contracts for Central Bankers\u201d, The American Economic Review<\/p>\n Websites<\/strong><\/p>\n Bank of England, \u201cMonetary Policy\u201d, accessed at http:\/\/www.bankofengland.co.uk\/monetarypolicy\/overview.htm on 22\/11\/2009<\/p>\n Bank of England, \u201cTreasury Committee enquiry into the Monetary Policy Committee of the Bank of England\u201d, accessed at http:\/\/www.bankofengland.co.uk\/publications\/other\/treasurycommittee\/mpc\/tsc070219.pdf on 23\/11\/2009<\/p>\n Bean , \u201cIs there a New Consensus In Monetary Policy?\u201d, accessed at http:\/\/www.bankofengland.co.uk\/publications\/other\/monetary\/bean070413.pdf on 23\/11\/2009<\/p>\n Blanchflower, \u201cThe Future of Monetary Policy\u201d accessed at http:\/\/www.bankofengland.co.uk\/publications\/speeches\/2009\/speech382.pdf on 24\/11\/2009<\/p>\n Clements, \u201cA Rogoff Interview\u201d, accessed at http:\/\/www.minneapolisfed.org\/publications_papers\/pub_display.cfm?id=4117 on 22\/11\/2009<\/p>\n Costain, \u201cThe Barro-Gordon model of Rules vs Discretion\u201d, accessed at http:\/\/www.econ.upf.edu\/~costain\/theory4\/bg.pdf on 22\/11\/2009 on 22\/11\/2009<\/p>\n Duncan, \u201cKing rounds on Cameron for trying to interfere in Quantitative Easing\u201d, accessed at http:\/\/www.thisislondon.co.uk\/standard-business\/article-23767982-king-rounds-on-cameron-for-trying-to-interfere-in-quantitative-easing.do on 22\/11\/2009<\/p>\n Spencer Dale 2009 \u00abInflation targeting: Learning the lessons from the financial crisis\u00bb http:\/\/www.bankofengland.co.uk\/publications\/speeches\/2009\/speech395.pdf<\/p>\n Svensson (2009), \u201cFlexible Inflation Targeting: Lessons from Financial Targeting\u201d, accessed at http:\/\/people.su.se\/~leosven\/papers\/090921e.pdf on 21\/11\/2009<\/p>\n","protected":false},"excerpt":{"rendered":" The theories surrounding monetary policy have been radically transformed in recent decades, ultimately shaping the institutional structure and policies of central banks.<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[11],"tags":[],"class_list":["post-88557","post","type-post","status-publish","format-standard","hentry","category-essaysbeauty-therapy"],"yoast_head":"\n